Morning Note: Bonds, China, Spain

1. The biggest holders of government bonds are banks. Banks are leveraged — the slope of the yield curve is much more important to them than the absolute level of interest rates. Also, they need high-quality bonds to use as collateral.

2. Insurance companies and pension funds. To the extent that these entities have nominal liabilities, the real risk of buying government bonds at current levels — i.e. erosion by inflation — does not apply (some may have real liabilities — I admit I do not know very much about this). Also, regulators make them buy government bonds.

3. Central banks and reserve managers. These tend to acquire government bonds for reasons other than their investment characteristics — e.g. maintaining a currency peg or quantitative easing.

In other words, a good three quarters of the market does not buy government bonds in order to generate real investment returns.

Rally-on-Sea

Shanghai’s drop may have come to an end — the market has been rallying in recent days. The reason is, perhaps, a view that China’s growth has touched a bottom. GDP growth for Q4 has just been reported at 8.1%, the lowest for some time, but IP and retail sales growth both edged up in March, and loan growth was very strong. I do not know what to make of this. If the economy is strengthening of its own accord, that means that monetary policy may not be tight enough to drive inflation out of the system (inflation also ticked up in March). That would imply tight policy for longer. On the other hand, there is much speculation that the government might consider 8.1% growth slow enough, in spite of the fact that it reduced its full-year target for 2012 to 7.5% (from 8% in 2011). Admittedly, the target has been exceeded for many years, suggesting that the government was happy for it to do so — but can that be assumed to continue in the course of a policy tightening? Actually, I really don’t know the answer. The main question in China at present is: when will the authorities ease. So, while following the (hopelessly bad) data is entertaining enough, Kremlinology is more important than economics for forecasting China’s economic performance this year. From that point of view, and given the instability around the leadership transition and the fact that inflation is more likely to spark serious protests than slower growth, I am inclined to think that the authorities will tend to err on the side of staying tight for too long, rather than not long enough.

2. Cash transactions about EUR 2500 have been banned, presumably to crack down on tax evasion (http://bit.ly/IIVBe7).

3. The rate of credit deflation is accelerating. Bank lending to households is now falling at 2% YOY, and bank deposit outflows are at -4% YOY. The former tells us that deleveraging is finally happening; the latter that depositors are losing faith in Spanish banks.

I try to avoid the “good heavens, did you know…!” school of analysis. So, what do these facts tell us? 1. suggests that Spain may have the same fundamental problem as Greece, which is that none of the society’s interest groups is prepared to take responsibility (i.e. a financial hit) for the good of the country. This was also the problem in Weimar Germany and, as in that case, the logical outcome would be inflation, were it not for the strictures imposed by the euro. Inside the euro, the logical outcome is an increasing fragmentation of society, as interest groups resist the measures imposed on them by governing politicians (whose incentives are, for now, to follow European prescriptions). 2. tells us something similar: that the moral obligation to pay tax is not strongly felt and hence that loyalty to the state is weak. 3. is not a terrible problem in the world of the LTRO, but it does suggest that, if things continue to deteriorate, the ECB will end up funding more and more of the Spanish banking system. It is hard to see how that could end well in the long run, but in the short term it should keep the show on the road. That, of course, means that there are further crisis episodes to come — the ECB is unlikely to act unless it has to (indeed, Bundesbankers are already blathering on about an exit from extraordinary monetary policy).

I really wonder whether a trade on Spain would be a good idea. Long Spanish CDS? Or long Spain, short Italy?